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Saturday, June 6, 2015

Why I Only Invest in Dividend Companies

I read this interesting post by Giraffe Value Investing, and that finally tipped me over and prompted me to write this post. This has been something I've been wanting to verbalize for a long time, but I guess it's better late than never. It's a bit messy because I have ideas jumping from place to place and it doesn't really fit into a nice clean structure, but oh so be it.

1) Pay out a dividend
2) Pay off debt
3) Buy back shares4) Do nothing about it

That's what a manager can do. However, regardless of what the managers do, shareholders can only be enriched in 2 ways - capital gains or dividend yield.

Enriching shareholders through dividend gains is pretty straight forward. The company has cash from the profits it made while conducting business. It doesn't need all the cash to maintain its operation and capex, so it returns the excess to shareholders. Shareholders immediately realize a return from the dividend. Dividends are straight forward, immediate returns that are locked up.

Enriching shareholders through capital gains is a bit more tricky, because the company technically cannot do much about its share price because it is not something entirely within their control. It can improve the business fundamentals to make it a more attractive and sustainable business, such as increasing earnings, reducing debt and securing moats, but at the end of the day, the share price is still dependent on market participants. Even if the company engages in share buybacks, they just become one of the many many many market participants splashing the stock price all over the place every other day.

Now, I think that a company that doesn't know what to do with their excess cash should not be fooling around with my money. You need money to maintain operations? Take it. You need money to grow the business through capex? Take it. Anything else, please give me back my money and I will allocate it myself, thank you very much.

A dividend policy forces a company's management to focus on sustainable profits and avoid excessive risk-taking. Take too much risk at the expense of profits, then BAM, whoever is responsible gets their head chopped off. This penalty system makes sure that cash isn't flowing into some pet project of one of the management or into stupid projects. With a clear dividend policy (and corresponding rewards), management is accountable and understand what their KPI is. It keeps both managers and owners on the same page and reduces agency issues.

Personally, I don't like the idea of selling away shares as the only option to realize gains through "cashing out all the accumulated dividends at your selected time". If the
business is a good business, I still want to own it. Even if its a bad business, maybe I want to hold onto it for sentimental reasons. If it's making too
much money and doesn't know what to do with it, dammit, give it back to
me to invest in other opportunities rather than sit on a huge cash hoard for
no good reason.

Psychologically
as an investor, dividends along the way helps to keep you motivated to
be invested in the stock. Something about having a random cookie every
once in a while just feels nice.

Other than psychologically
helping to keep you invested, dividends paid out are also locked-in, realized
gains that cannot be "lost" back to the market. If all your returns
were so far in unrealized capital gains, that could disappear if share
price drops. Dividends that is paid out and sitting in your bank account
does not disappear. It is a way of casually and consistently de-risking the amount of capital that you have at risk in the market.

Most importantly though, the main flaw of "capital gains" investing strongly assumes that one is not only willing to sell their securities, but is also skilled enough to know when to sell and how much to sell. As I've mentioned before, I think most investors as a whole (including myself) are just downright horrible when it comes to selling. Buying is no problem. Buy whatever stock you want, whenever you want, people that observe just shut up and smoke a cigar. Sell something, especially a stock that they also have in their portfolio, then boom, all the FBI-level interrogations and mind-control comes out convincing you why you should not sell the stock - and be just like them.

On the practical front, having a portfolio that pays out dividends allows you to better fine-tune the allocation of the payout money. Instead of only being restricted to "reinvest" into the source company, you are able to browse through your own portfolio and selectively deploy your paid out dividends into more attractive companies. Maybe a company you own is suffering from a bad quarter and an emotional sell off. Buy into it. Maybe a company you own is surging on speculative news. Don't reinvest into it. Having dividends allow you that luxury of fine-tuning your allocation, which basically means allowing you to buy low, sell high.

In a bigger picture, dividends paid out can also be chosen not to be even re-invested at all. Let's say the market has been in a massive bull run and stocks feel over-valued to you. You don't feel like getting off the train early, but you also don't want to enter at these valuations. You just sit tight with cash in hand and you can build up a warchest while waiting for a correction. When (not if, because it always comes) it comes, you will have the cash to pick up attractively priced stocks.

When a bear market comes, it is entirely within reason and possibility that a company cuts or reduces its dividend. If the company is facing issues that is an industry problem or even a more general economic problem, why shouldn't it be able to decide to be more conservative with its cash? Dividends aren't conjured up from the air. Paying out cash in tight times leaves the company in a riskier position. A good management looks at the big picture and in the long term, and that might mean a short term sacrifice in dividends for that year or few. Personally, I don't think it is a sin, but it seems to me that many people write off stocks like that. Not only do I not mind, I freaking love it. Less competition for those stocks.

Don't get me wrong, I'm not saying to only pick companies based on dividend yields. There's a hundred different metrics to use, why limit yourself to one? Picking companies based solely on dividend yields is probably a recipe for disaster and I wouldn't be surprised if what you get is mostly right-pocket-to-left-pocket-investing.

I don't even care about dividend growth. I don't need my dividend to grow. It would be nice if it did. But for some investments, I am perfectly happy with a stagnant dividend if stock price can remain relatively stable as well. Decent positive total returns is what I want. A good example of this would be mature REITs. They are almost considered bond proxies because of their stable income and market value.

So does preference to dividend stocks generically "depend on strategy"? Unfortunately for the people looking for the secret answer to get rich quick, my answer would be that "it depends".

There are many ways to invest, just like there are many ways to get to
Rome. The path that everyone takes to get there may be different. Some
may have taken longer. Some may have spent more money. But if the final
goal is getting to Rome and they got there, does it really matter? Many
may have taken the path that you preach and extoll, but will all your
followers reach Rome?

The path might be the same, but each traveller is different, so the journey may be different as well.

It is my personal preference to invest in dividend paying companies because it suits my personality and investing style. I believe that with all the knowledge I have learnt so far, combined with the skills and tools that I have, taking the path of dividend paying stocks is one of my better methods that suits me.

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